What Is Invested Income and How Is It Taxed?

Investment income is the return generated from your capital, meaning the money you have invested. This stands in contrast to earned income, which is compensation received for labor, such as salaries, wages, and commissions. Essentially, investment income is your money working for you, while earned income is you working for money.

This distinction has implications for financial planning and how your income is taxed. While earned income covers daily living expenses, investment income can be a tool for building long-term wealth and achieving financial goals like retirement.

Sources of Investment Income

Dividends

Dividends represent a sharing of a corporation’s profits with its shareholders. When a company earns a profit, its board of directors may distribute a portion of those earnings to stockholders. Companies can issue dividends on various schedules, such as monthly, quarterly, or annually, providing a predictable cash flow.

Interest

Interest is the income earned from lending your money to an entity, such as a bank, corporation, or government. This can come from sources including savings accounts, certificates of deposit (CDs), and bonds. When you purchase a bond, you are loaning funds to the issuer for periodic interest payments over a set term.

Capital Gains

A capital gain is the profit realized when you sell an asset for a higher price than you paid for it. These assets can include stocks, bonds, and real estate. An unrealized gain is a potential profit on an asset you still own, while a realized gain becomes income only when the asset is sold.

Rental Income

Rental income is generated from leasing out property that you own. This can include residential properties like houses or apartments, as well as commercial real estate. The income received from tenants constitutes rental income.

Tax Treatment of Investment Income

Ordinary Income Rates

Certain types of investment income are taxed at the same rates as your salary or wages. This category includes interest income from savings accounts and corporate bonds, as well as non-qualified dividends. These earnings are added to your other income and are subject to the standard federal income tax brackets, which in 2025 range from 10% to 37%.

Preferential Tax Rates

Preferential tax rates are applied to long-term capital gains and qualified dividends. For an asset sale to result in a long-term capital gain, you must have held the asset for more than one year. Gains from assets held for one year or less are considered short-term and are taxed at ordinary income rates. Long-term capital gains are taxed at lower rates of 0%, 15%, or 20%, depending on your taxable income and filing status.

Similarly, qualified dividends receive this favorable tax treatment. For a dividend to be “qualified,” it must be paid by a U.S. corporation or a qualifying foreign corporation, and you must meet a specific holding period for the stock. This structure encourages long-term investment over short-term speculation.

Net Investment Income Tax (NIIT)

Higher-income investors may be subject to an additional tax known as the Net Investment Income Tax (NIIT). This is a 3.8% tax that applies to the lesser of your net investment income or the amount by which your modified adjusted gross income (MAGI) exceeds certain thresholds. The thresholds are $200,000 for single filers, $250,000 for those married filing jointly, and $125,000 for those married filing separately.

The NIIT is levied on top of any capital gains or ordinary income taxes you already owe. Net investment income for this purpose includes interest, dividends, capital gains, rental and royalty income, and passive business income. It does not apply to wages, Social Security benefits, or distributions from most retirement plans like 401(k)s and IRAs.

Investment Account Types

Taxable Accounts

A standard brokerage account is a common type of taxable investment account. In these accounts, you invest with after-tax dollars, and any income generated, such as interest, dividends, or realized capital gains, is subject to tax in the year it is received. This means you will pay taxes annually on the earnings from your investments.

These accounts offer flexibility, as there are no limits on how much you can contribute and no restrictions on when you can withdraw your funds. This makes them suitable for a wide range of financial goals, both short-term and long-term. The ability to access your money at any time without penalty distinguishes them from retirement-focused accounts.

Tax-Advantaged Accounts

Tax-advantaged accounts, such as Traditional and Roth IRAs or 401(k)s, provide tax benefits to encourage saving for retirement. The tax treatment depends on the type of account, but the main benefit is that investments can grow without being taxed annually on dividends, interest, or capital gains.

With a Traditional IRA or 401(k), contributions may be tax-deductible, and the investments grow tax-deferred. You pay taxes on withdrawals in retirement, at which point distributions are taxed as ordinary income. A Roth IRA or Roth 401(k) is funded with after-tax dollars, so qualified withdrawals in retirement are tax-free.

Reporting Investment Income to the IRS

Information Returns (1099 Series)

At the end of the tax year, you will receive informational returns from the financial institutions holding your investments. These forms, part of the 1099 series, report your investment income to you and the IRS. Common forms include Form 1099-DIV for dividends, Form 1099-INT for interest income, and Form 1099-B for proceeds from asset sales.

Form 1099-DIV will break down your dividends into ordinary and qualified categories, which is necessary for applying the correct tax rates. Form 1099-B provides details on the sale of assets, including the proceeds, which you will need to calculate your capital gains or losses.

Tax Schedules

The information from your 1099 forms must be transferred to the appropriate schedules on your Form 1040 tax return. If your total taxable interest or ordinary dividends exceed $1,500, you are required to file Schedule B. This schedule provides a detailed breakdown of the sources of your interest and dividend income.

For reporting capital gains and losses, you will use Form 8949 and Schedule D. You use Form 8949 to list the details of each asset sale, reconciling the information with your Form 1099-B. The totals from Form 8949 are then summarized on Schedule D, which calculates your net short-term and long-term capital gains or losses.

Form 8960

If your income exceeds the specified thresholds, you may also need to file Form 8960, Net Investment Income Tax. This form is used to calculate the additional 3.8% NIIT on your investment income. The final tax liability calculated on Form 8960 is then reported on your Form 1040.